Introduction to Company Formation

The landscape of modern business is defined by its scale and complexity. Ventures, especially those in the medium and large-scale sectors, require substantial financial investment to get off the ground and compete effectively. This environment of increasing competition and rapid technological change also brings a significantly higher level of risk. Consequently, the company form of organisation has emerged as the preferred structure for many business ventures. Its primary advantages are its unique ability to pool large amounts of capital from numerous investors and the crucial benefit of limited liability, which protects the personal assets of its owners from business debts.

The journey from the spark of a business idea to the creation of a legally recognized company ready to commence its operations is a structured process known as the formation of a company. This process is a sequence of distinct stages, each involving specific legal and procedural formalities. The visionary individuals who initiate this journey, navigate its complexities, and assume the initial risks associated with bringing the enterprise to life are called the promoters of the company.

Consider the example of Avtar, a brilliant automobile engineer who invents a new carburettor capable of drastically reducing a car's fuel consumption. To manufacture and market this innovation on a large scale, he needs significant capital and a structure to manage the inherent risks of launching a new product. A sole proprietorship or a partnership would be inadequate due to unlimited liability and limited fundraising capacity. The ideal structure for Avtar's ambitious project is a company. This chapter details the formalities and stages involved in transforming such a business idea into a living, breathing corporate entity.

Formation of a Company

The formation of a company is not a single event but a complex and systematic process that demands the meticulous completion of various legal formalities and procedures. To understand this intricate process clearly, it can be broken down into three distinct and sequential stages:

1. Promotion: The initial stage of conceiving the business idea and assessing its viability.

2. Incorporation: The legal process of registering the company to give it a separate legal existence.

3. Capital Subscription: The process of raising the necessary funds to finance the company's operations.

It is crucial to note that while these stages provide a general framework, their applicability differs based on the type of company. A private company, for instance, is legally prohibited from inviting the public to subscribe to its shares. Therefore, it completes its formation after the incorporation stage and does not need to undertake the Capital Subscription stage, which involves issuing a prospectus and fulfilling the requirement of minimum subscription. This third stage is exclusively for public companies that intend to raise capital from the general public.

Promotion of a Company

Promotion is the first, most crucial, and often the most challenging stage in the formation of a company. It is the entrepreneurial process of discovery, investigation, and assembly. It encompasses all the activities from conceiving a business idea to taking the necessary steps to give that idea a practical and corporate form. The process is initiated when an individual or a group of individuals identifies a potential business opportunity and decides to undertake the risk of exploiting it by forming a company.

Who is a Promoter?

A promoter is the architect of a business venture. They are the person or group of persons who undertake the task of forming a company for a given project. Promoters are the ones who conceive the business idea, analyse its future prospects, assemble the necessary resources (men, materials, machinery, and finance), and take all the required procedural steps to set the organization in motion.

The Companies Act provides a functional definition of a promoter. According to Section 69, a promoter is a person:

• Who is named as such in the company's prospectus or is identified by the company in its annual return;

• Who has control over the affairs of the company, either directly or indirectly, in their capacity as a shareholder, director, or otherwise; or

• In accordance with whose advice, directions, or instructions the company's Board of Directors is accustomed to act. (This does not include individuals who provide advice purely in a professional capacity, such as a lawyer or an accountant giving professional advice).

In essence, promoters are the visionaries who perform all the preliminary functions necessary to bring a company into existence, from the initial feasibility studies to getting it registered and ready to commence its business operations.

Functions of a Promoter

The promoters of a company perform a series of vital and diverse functions to transform a business idea into a functioning corporate entity. These functions lay the entire groundwork for the new company.

(i) Identification of Business Opportunity

The promoter's journey begins with the identification of a viable business opportunity. This is the entrepreneurial spark. The opportunity could be an idea for a completely new product or service, a novel way to deliver an existing product to the market, or leveraging a new technology. The promoter conceives this idea and initiates a thorough investigation to explore its potential.

(ii) Feasibility Studies

Not every promising idea is a commercially viable project. To avoid wasting resources on a doomed venture, promoters undertake detailed feasibility studies to rigorously investigate all aspects of the proposed business. These studies are critical for risk assessment and are often conducted with the help of specialists like engineers, chartered accountants, and market analysts. The main types of feasibility studies are:

(a) Technical Feasibility

This study assesses whether the business idea is technically possible to execute. It examines factors such as the availability and accessibility of the necessary raw materials, technology, machinery, and skilled labour. If a critical component cannot be procured or a required technology is unproven or prohibitively expensive, the project may be deemed technically unfeasible.

(b) Financial Feasibility

This study evaluates the financial viability of the project. Promoters must estimate the total capital required for setting up the business (fixed capital) and for running its day-to-day operations (working capital). They then assess the potential sources from which these funds can be raised. If the required financial outlay is so large that it is beyond the capacity of the promoters to arrange, the project must be abandoned. For example, a plan to build a new airport might be profitable, but if securing the thousands of crores in funding is not possible, it is financially unfeasible.

(c) Economic Feasibility

This is the ultimate test of the project's viability. It analyses the potential profitability of the business. Even if a project is technically possible and financially securable, it will be abandoned if it is unlikely to generate a profit. This involves a detailed cost-benefit analysis, market demand forecasting, competitive analysis, and projecting the potential return on investment. The project is only pursued if the expected returns justify the investment and the associated risks.

Only when all these feasibility studies yield positive and encouraging results will the promoters make the final decision to proceed with forming the company.

(iii) Name Approval

Once the decision to form a company is made, the promoters must select a suitable and legally permissible name for it. They must then submit an application to the Registrar of Companies (ROC) of the state where the company's registered office will be located. To increase the chances of a quick approval, promoters typically provide three names in order of their preference. The proposed name will be approved only if it is not considered undesirable. A name is considered undesirable if:

• It is identical to or too closely resembles the name of an existing registered company.

• It is misleading, for instance, by using words like 'National', 'Corporation', or 'Universal' in a way that suggests a scale of operations or a connection to the government that is not true.

• It violates the provisions of ‘The Emblems and Names (Prevention of Improper Use) Act, 1950’, which prohibits the use of names of national importance or international bodies like the UNO or WHO.

(iv) Fixing up Signatories to the Memorandum of Association

The promoters must decide on the individuals who will sign the Memorandum of Association (MOA). The MOA is the company's charter document, and its signatories are the first members of the company. The people who sign the MOA are typically also the first directors of the company. A public company requires at least seven signatories, while a private company requires a minimum of two. The promoters must obtain the written consent of these proposed directors confirming their willingness to act in that capacity.

(v) Appointment of Professionals

Promoters appoint various professionals to provide expert assistance with the complex legal and financial formalities of company formation. These professionals include mercantile bankers to advise on capital structure, auditors to handle financial matters, lawyers to ensure legal compliance, and company secretaries to manage the documentation process. These experts help in preparing and filing the necessary legal documents with the Registrar of Companies.

(vi) Preparation of Necessary Documents

The final and most crucial function of the promoter is to oversee the preparation of the key legal documents required for the registration of the company. These documents form the legal foundation of the company and must be meticulously drafted. The most important of these are the Memorandum of Association and the Articles of Association.

Documents Required for Submission

To successfully register a company under the Companies Act, the promoter must prepare and submit a set of crucial legal documents to the Registrar of Companies (ROC). These documents define the company's identity, purpose, and internal governance.

A. Memorandum of Association (MOA)

The Memorandum of Association is the most important document of a company, often described as its charter or constitution. As defined in Section 2(56) of the Companies Act, 2013, it defines the company's relationship with the outside world. It specifies the company's objectives and the scope of its activities. A company cannot legally undertake any activity that is not mentioned in its MOA. Any act done beyond the scope of the MOA is considered ultra vires (beyond powers) and is legally void. The MOA contains several distinct and mandatory clauses:

(i) The Name Clause

This clause contains the full and exact name of the company as approved by the ROC. The name of a public limited company must end with the word "Limited", and a private limited company must end with the words "Private Limited".

(ii) Registered Office Clause

This clause specifies the name of the State in which the registered office of the company is to be situated. This determines the jurisdiction of the ROC and the courts. The exact address of the registered office is not required at this stage but must be notified to the ROC within thirty days of the company's incorporation.

(iii) Objects Clause

This is the most critical clause as it defines the purpose for which the company has been formed. It lists the main objects the company will pursue upon its incorporation. The company is not legally permitted to undertake any activity that is not directly stated in this clause or is not incidental to achieving the main objects.

(iv) Liability Clause

This clause explicitly states that the liability of the members is limited. For a company limited by shares, it specifies that a member's liability is limited to the nominal value of the shares they hold. For example, if a shareholder holds 1,000 shares of ₹10 each and has already paid ₹6 per share, their maximum future liability is only ₹4 per share (a total of ₹4,000), regardless of the company's debts.

(v) Capital Clause

This clause specifies the maximum amount of share capital that the company is authorised to raise through the issue of shares during its lifetime. This is known as the Authorised Share Capital. The clause also details how this capital is divided into shares of a fixed face value (e.g., an authorised capital of ₹25,00,000 divided into 2,50,000 shares of ₹10 each). A company cannot issue share capital beyond this authorised limit without first altering its MOA.

The MOA must be signed by at least seven persons in the case of a public company and by at least two persons in the case of a private company.

B. Articles of Association (AOA)

If the MOA is the company's constitution, the Articles of Association are its by-laws. The AOA contains the rules and regulations for the internal management and day-to-day administration of the company. These rules are subsidiary to the MOA and must not contradict it or the Companies Act. The AOA outlines matters such as the powers and duties of directors, procedures for conducting meetings, voting rights of members, and the process for share allotment and transfer. While it is compulsory for a private company and an unlimited company to have their own AOA, a public limited company can choose to adopt Table F of the Companies Act, 2013, which provides a comprehensive model set of articles.

C. Consent of Proposed Directors

A written consent from each person who is named as a director in the Articles of Association is required. This document serves as proof that they have agreed to act as a director. It also includes an undertaking that they will buy and pay for their qualification shares, which is the minimum number of shares a director must hold to be eligible for the position, as specified in the AOA.

D. Agreement

If the company proposes to enter into an agreement with any individual for their appointment as a Managing Director, whole-time Director, or Manager, a copy of that proposed agreement must be submitted to the ROC.

E. Statutory Declaration

A declaration must be submitted to the ROC, affirming that all legal requirements of the Companies Act pertaining to the registration process have been duly complied with. This declaration acts as a formal attestation of compliance and can be signed by an advocate of a High Court or Supreme Court, a practicing Chartered Accountant, or by a person named in the company's articles as a director or manager.

F. Receipt of Payment of Fee

Proof of payment of the required registration fee must be submitted along with the other documents. The amount of this fee is determined by the authorised share capital of the company as stated in its MOA.

Position of Promoters

Promoters are the visionaries who bring a company to life, but their legal position is unique and complex. Legally, they are neither considered agents nor trustees of the company they are in the process of forming. They cannot be agents because their principal—the company—does not yet exist. Similarly, they are not trustees in the formal sense. This unique status has significant implications for their rights and liabilities.

Liability for Pre-incorporation Contracts

Because the company does not exist before its incorporation, promoters who enter into contracts on its behalf are personally liable for those contracts. These are known as preliminary or pre-incorporation contracts. For example, if a promoter leases an office space or orders machinery for the proposed company, the promoter is personally bound by that contract. After incorporation, the company cannot simply 'ratify' or adopt these pre-existing contracts, as an agent's actions cannot be ratified by a principal that did not exist at the time of the act. However, the company can choose to enter into a fresh contract (a process called novation) on the same terms with the third party, which would then absolve the promoter of their liability.

Fiduciary Duty

Promoters stand in a fiduciary position in relation to the company they promote. This is a position of utmost trust and confidence, which imposes a duty on them to act honestly and in the best interests of the company. A key aspect of this duty is that they must not make any secret profits at the company's expense. If a promoter makes a personal profit from a transaction with the company (e.g., by selling their own property to the newly formed company at an inflated price), they must make a full and frank disclosure of their interest in the transaction to an independent Board of Directors. If they fail to do so, the company has the right to rescind (cancel) the contract and recover any profit made by the promoter.

Remuneration and Expenses

Promoters are not legally entitled to claim any remuneration or the expenses they incur during the promotion process. However, in practice, a company, after its incorporation, may choose to reimburse them for these legitimate pre-incorporation expenses. The company can also decide to remunerate the promoters for their entrepreneurial efforts and risk-taking. This remuneration can take various forms, such as paying them a lump-sum fee, granting them a commission on property purchased or shares sold, or allotting them shares or debentures in the company.

Incorporation

Incorporation is the second and pivotal stage of company formation. It is the formal process of registering the company with the government, which results in the company being born as a distinct legal entity. After the promotion stage is complete and all necessary documents have been prepared, the promoters file an application for incorporation with the Registrar of Companies (ROC) of the state in which the company's registered office is to be situated.

Process of Incorporation

The application for registration must be accompanied by the set of crucial documents detailed earlier, including the Memorandum of Association and Articles of Association (duly stamped, signed, and witnessed), the written consent of proposed directors, and the statutory declaration of compliance. The Registrar will meticulously scrutinize these documents to ensure they are complete and conform to the provisions of the Companies Act. If the Registrar is satisfied with the application and the submitted documents, they will enter the company's name in the official Register of Companies and issue a Certificate of Incorporation. From the date mentioned on this certificate, the company officially comes into legal existence. Along with the certificate, the ROC also allots a unique Corporate Identity Number (CIN) to the company.

Effect of the Certificate of Incorporation

The Certificate of Incorporation is the company's official birth certificate. It has profound legal effects:

• Separate Legal Entity: The company becomes an artificial legal person, entirely distinct from its members (shareholders) and directors.

• Perpetual Succession: The company's existence is continuous and is not affected by the death, insanity, or insolvency of its members. Its life can only be ended through the legal process of winding up.

• Power to Contract: The company can now enter into valid contracts, own property, sue, and be sued in its own name.

Crucially, the Certificate of Incorporation is considered conclusive evidence of the regularity of the company's registration. Once the certificate is issued, the company's legal existence cannot be challenged on the grounds of any procedural defect or irregularity in its formation. For example, even if it is later discovered that some signatures on the MOA were forged, the incorporation itself remains valid. This legal principle is vital as it protects innocent third parties who enter into contracts with the company in good faith. The only remedy for a company registered through fraudulent means or for illegal objects is to initiate the legal process of winding it up.

Director Identification Number (DIN)

The Companies Act mandates that every individual who intends to be appointed as a director of a company must first obtain a Director Identification Number (DIN). This is a unique identification number allotted by the Central Government. An individual cannot be appointed as a director without having a valid DIN, and no person can hold more than one DIN. This helps in maintaining a database of directors and ensuring accountability and transparency in corporate governance.

Capital Subscription

Capital Subscription is the third stage of company formation and is a process undertaken exclusively by public companies that intend to raise funds from the general public. A private company is legally prohibited from making a public offer and therefore does not go through this stage. This stage involves the complex and highly regulated process of inviting the public to subscribe to the company's shares and debentures to raise the necessary capital for its operations.

Steps for Raising Funds from the Public

(i) SEBI Approval

The Securities and Exchange Board of India (SEBI) is the apex regulatory authority for the capital markets in India. Its primary role is to protect the interests of investors. Therefore, any public company planning to raise funds from the public must comply with SEBI's stringent guidelines regarding disclosure of information. The company must not conceal any material facts and must provide all relevant information in its offer documents so that potential investors can make a well-informed decision. The draft offer document has to be filed with SEBI, and its observations must be incorporated before the issue can open.

(ii) Filing of Prospectus

A prospectus is a formal legal document that serves as an invitation to the public to subscribe to a company's securities (shares, debentures, etc.). It must be filed with the Registrar of Companies (ROC) before it is issued to the public. The prospectus contains exhaustive information about the company, its promoters and management, its financial performance, the objectives of the fundraising, and a detailed analysis of the risks involved. It is the primary document on which investors base their investment decisions.

(iii) Appointment of Bankers, Brokers, and Underwriters

Raising public funds is a massive undertaking that requires a network of intermediaries. The company appoints bankers to receive and process the application money from investors. It appoints registered brokers to distribute application forms and market the issue to the public. To ensure the success of the issue and to safeguard against the risk of under-subscription, the company often appoints underwriters. Underwriters are financial institutions that guarantee to buy any shares that are not subscribed by the public, for which they charge an underwriting commission.

(iv) Minimum Subscription

To prevent companies from starting business with insufficient funds, the law mandates the concept of 'minimum subscription'. According to SEBI guidelines, a company must receive applications for at least 90 per cent of the entire issue size offered to the public. If this threshold is not met, the allotment of shares cannot proceed, and the company must refund the entire application money received from the applicants within a stipulated time frame.

(v) Application to Stock Exchange

A public company must apply to at least one recognized stock exchange (like the BSE or NSE) for permission to have its shares or debentures listed. Listing allows the securities to be traded freely on the stock exchange, providing investors with an exit route and liquidity for their investment. If the stock exchange does not grant this permission, the allotment of shares is considered void, and all application money must be refunded.

(vi) Allotment of Shares

Once the subscription period is over and the minimum subscription has been successfully achieved, the company proceeds with the allotment of shares. In case of oversubscription (where applications are received for more shares than were offered), allotment is done on a pro-rata basis as per SEBI guidelines. Allotment letters are then issued to the successful applicants. If an applicant is allotted fewer shares than they applied for, or no shares at all, the excess application money is either refunded or adjusted towards future calls on the allotted shares. After the allotment is complete, the company must file a document called the 'Return of Allotment' with the ROC within 30 days.

It is important to note that if a public company decides to raise funds privately (from a select group of friends, relatives, or institutional investors) instead of from the public, it does not need to issue a prospectus. In such a case, it must file a document called a 'Statement in Lieu of Prospectus' with the ROC at least three days before making the allotment.

Memorandum of Association vs. Articles of Association

The Memorandum of Association (MOA) and the Articles of Association (AOA) are the two foundational documents of a company. While both are essential for its governance, they serve fundamentally different purposes and have a distinct legal hierarchy.

One Person Company (OPC)

A significant and progressive innovation introduced by The Companies Act, 2013, is the legal framework for a One Person Company (OPC). This structure was created to encourage entrepreneurship and to enable the corporatisation of the vast unorganized sector of micro-businesses and sole proprietorships, which form the backbone of the Indian economy.

Concept and Benefits of OPC

An OPC is a hybrid structure that is registered as a private company but has only one person as its member (shareholder). It masterfully combines the simplicity and complete control of a sole proprietorship with the significant advantages of a corporate form of organisation. Its key benefits for an individual entrepreneur include:

• Separate Legal Entity: The OPC is recognized as an artificial person in the eyes of the law, completely distinct from its owner. It can own assets and incur debts in its own name.

• Limited Liability: This is the most crucial benefit. The owner's liability is limited to their investment in the company. Their personal assets are shielded from business liabilities, providing a significant safety net.

• Perpetual Succession: The company's existence is continuous. The death or incapacity of the sole member does not bring the company to an end, as ownership is seamlessly transferred to a pre-appointed nominee.

Furthermore, the legal and compliance regime for an OPC is simpler and less burdensome compared to a standard private limited company, making it an ideal and attractive option for individual entrepreneurs to formalize their business.

Key Characteristics and Rules for OPC

1. Eligibility: Only a natural person who is an Indian citizen and also a resident in India is eligible to incorporate an OPC. A "resident in India" is defined as a person who has stayed in India for a period of not less than 182 days during the immediately preceding calendar year.

2. Nominee Requirement: The sole member must, at the time of incorporation, nominate another eligible individual (who gives their consent) to act as the nominee. This nominee will become the member of the company in the event of the sole member's death or incapacity, ensuring perpetual succession.

3. Restrictions on Number: An individual is permitted to incorporate only one OPC and can be a nominee in only one other such company. This prevents the misuse of the OPC structure.

4. Minor Ineligibility: A minor cannot become a member or a nominee of an OPC, nor can they hold any share with a beneficial interest.

5. Restrictions on Business Activities: An OPC cannot be incorporated as a Section 8 company (a company for charitable or non-profit purposes). It is also prohibited from carrying out Non-Banking Financial Investment (NBFI) activities, including investing in the securities of other corporate bodies.

6. Conversion Rules: An OPC cannot voluntarily convert itself into any other kind of company (like a private or public limited company) until two years have passed from its date of incorporation. However, conversion becomes mandatory if its paid-up share capital increases beyond fifty lakh rupees or if its average annual turnover during the relevant period exceeds two crore rupees.

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